Trading basics: Understanding short selling

Julie Brownlee, Fsp Invest, 17 Sep. 2014

Tags: short selling, short sell, what is short selling, short selling risks, trading, trading strategies,

Not only can you buy shares in the hope of making a profit, you can do the opposite. That is, you can sell shares (you don’t own) in the hope of buying them back at a later date at a lower price.

This is called short selling.

So how does short selling work? And how can you short sell shares?

Read on to find out…

What is short selling?

Short selling is when a trader tries to profit from a fall in the price of an asset.

For example, a hedge fund manager thinks that a company’s shares are overvalued and due a fall. He can borrow some shares from an existing shareholder in return for a fee. This fee is usually an interest payment.

He then sells the shares on the stock market and hopes the price will fall. If it does, he can buy them back at a cheaper price and make a profit.

Short selling in action

Let’s say Mike is a hedge fund manager. He sees that Company ABC’s shares are trading at R100. But he thinks they will fall to R70.

So he borrows 1,000 shares and sells them at R100 each. He now has R100,000. But he’s also ‘short’ of 1,000 shares as he’ll eventually have to return them to the original lender.

If the share price drops to R70 as he anticipates, he can buy them back for R70,000. He’ll return them to the lender and pocket R30,000 in profit.

But what happens if the share price rises to R150? He could face a loss of R50,000.

The risks of short selling

There is theoretically no limit to your losses as the upside to shares is technically infinite. This is what makes short selling so risky.

This is why traders embarking on short selling need to understand the risks before they undertake trading of this kind.

How you can short sell

In South Africa, you can short sell shares by using derivatives such as single stock future, spread trading and contracts for difference (CFDs).

So there you have it. What you need to know to understand short selling.

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